Monday, September 19, 2011

Return on invested capital (ROIC)

What It Is:

Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders.  ROIC tells us how good a company is at turning capital into profits.

How It Works/Example:

The general equation for ROIC is:  ( Net income - Dividends ) / ( Debt + Equity )

ROIC can also be known as "return on capital" or "return on total capital."

For example, Manufacturing Company MM lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. Its business operations are straightforward -- MM makes and sells widgets.
We can calculate MM's ROIC with the equation:

ROIC = ( Net income - Dividends ) / ( Debt + Equity )
         = (100,000 - 0) / (500,000 + 100,000) = 16.7%

Note that for some companies, net income may not be the profitability measure you want to use. You want to make sure that the profit metric you put in the numerator is giving you the information you need.

ROIC is most useful when you're using it to calculate the returns generated by the business operation itself, not the ephemeral results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they're not really recurring results from business operations. Try to think of what your business "does" and only consider income related to that core business.

For example, Conglomerate CC lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. But when you look at CC's income statement, you notice a lot of extra line-items, like "gains from foreign currency transactions" and "gains from one-time transactions."

In the case of CC, if you use the net income number, you can't be very specific as to where the returns are being generated. Were they from strong business results? Were they from fluctuations in the foreign currency markets? Did CC sell a subsidiary?

For CC, it would make more sense to use an income measure called net operating profits after tax (NOPAT) as the numerator. It's not found on the income statement, but you can derive it yourself with the following equation:

NOPAT = Earnings Before Interest & Taxes * (1 - Tax Rate)

Using NOPAT in the equation will tell you the return the company generated with its core business operations for both its bondholders and stockholders.

Why It Matters:

A firm's ROIC can be an excellent indicator of the size and strength of its moat. If a company is able to generate ROIC of 15-20% year after year, it has developed a great method for turning investor capital into profits.

ROIC is especially useful for companies that invest a large amount of capital, like oil and gas firms, computer hardware companies, and even big box stores. As an investor, it's important to know that if a company takes your money, you'll get an adequate return on your investment.

Another Example:

The return on invested capital is the amount of money an investor earns for a given investment. The return on invested capital, or return on investment as it is often called, allows investors to determine how much they make on a given investment. It is a useful tool to measure whether an investment is a good investment or a bad investment.

Capital refers to the amount of money an individual invests in a given investment source. For example, an individual could invest $100 US Dollars (USD) to purchase a stock. In this case, the return on invested capital would refer to the amount of money the investor makes in relation to the original $100 USD investment.

The return on invested capital is a useful measure to determine whether an investment is a good one or not. It can also be used to compare different investments, by comparing the return on the investment. For example, if one investment has a higher return on investment than another, the company with the higher rate of return is the better investment, assuming all other variables such as riskiness of the investment are the same.

To calculate the return on investment, the money invested must be compared to the money made. For example, if a $100 USD investment earns $50 USD, this rate of return is a better rate of return than if a $500 USD investment returns $50 USD. Thus, this allows investors to compare the performance of different investments when the investor puts a different amount of money into each respective investment.

Calculating the return on investment is simple. The cost of the investment is subtracted from the gain on the investment and that number is divided by the cost of the investment. For example, assume an investor purchased $100 USD worth of stock and made $50 USD on his investment. The return on investment would be equal to $150 USD - $100 USD / $100 USD, or a 50 percent return on invested capital.

This ratio can be used when evaluating stock purchases or when comparing the performance of respective products. If a product cost $100 USD to make and the profit on the product was $150 USD, the same return on investment calculation described above could be used to determine which product was a better investment, and thus which product was a better producer for the company. Because of the simplicity of the equation, performing this type of equation is common in business and investing applications.
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